NY futures continued to advance this week, with March gaining another 222 points to close at 61.79 cents.

Since starting to move higher on January 26, the March contract has gained more than 450 points and managed to move through some key resistance levels, crossing above a five-month downtrend line and a cluster of moving averages all the way up to the 100-day. A look at the candlestick chart shows that buyers are now firmly in control of the market, with only two out of the last nine sessions closing slightly below their opening level.

The technical strength aligns nicely with what we have been witnessing in the cash market, where around two million bales of US cotton have been sold in the four weeks leading up to January 29. The latest US export sales report came in above expectations, as 460’700 running bales of Upland and Pima cotton were sold to 19 different markets last week. Vietnam and China continued to lead the charge, taking once again more than 300’000 bales combined. Total commitments for the current marketing year have now reached 9.9 million statistical bales or nearly as much as the current USDA estimate of 10.0 million bales, and we are just halfway through the season.

The US balance sheet is starting to tighten up considerably, similar to what we saw happening last season. Out of a total supply of 18.5 million bales we now have around 13.7 million bales committed between export sales and domestic mill use, while a year ago we had total supply at 17.0 million bales and commitments at 12.8 million bales. In other words, the current 4.8 million bales of unsold cotton are comparable to the 4.2 million bales that were still available a year ago, especially if we adjust the numbers for Pima, which had higher commitments last season.

However, there are a couple of key differences to last year. First of all the March contract was trading at 86.31 cents, or nearly 25 cents higher than now. But more importantly, March was trading at a 900-point inversion over December, which caused mills to slow down purchases of current crop cotton as they tried to stretch into cheaper new crop pricing. This is not the case at the moment, with current crop still trading at a discount to new crop.

Furthermore, with Brazil and Australia producing nearly 3 million bales less this season, the supply of machine-picked high grades is not as abundant as a year ago. Mills therefore don’t have the luxury of waiting for cheaper prices down the road as they did last season, especially with plantings in the US expected to be lower in 2015/16. Therefore, while the US statistical situation is fairly similar to where it was last February, there is a greater incentive for mills to keep on buying US cotton as we head into spring and summer.

The latest CFTC report as of January 26 showed something rather unusual, namely speculators being 9’800 contracts more net short than the trade, which is only the second time that has ever happened! The first time was on September 30, 2014, when speculators had 8’304 more net shorts than the trade. Traditionally the trade tends to be on the short side, while speculators operate mostly from a net long position. Only after the emergence of index funds around a decade ago has it even become possible for the trade and speculators to be on the same side of the ledger.

While the net positions paint a fairly benign picture, with specs at 2.9 million net short, the trade at 2.0 million net short and Index funds at 4.9 million net long, the outright positions look a lot more troublesome. For example, speculators owned a 9.0 million bales outright short position on January 26, which is a record! Not even during the height of the financial crisis did speculators own more outright shorts than that. In addition to these specs shorts, the trade still had 11.0 million bales in outright shorts, while index funds were at 0.6 million bales. On the long side we had speculators with 6.1 million in outright longs, the trade with 9.0 million and Index funds with 5.5 million bales.

There are several reasons why speculators are leaning so heavily on the short side this season, such as the negative outlook for commodities in general, fears of deflation, a stronger dollar and a global cotton balance sheet with an inventory nearly as large as a year’s worth of consumption. However, while these may all be valid reasons to see the cotton world at large in a negative light, they will do little to avert a potential short squeeze in the futures market.

So where do we go from here? We believe that we currently have a perfect set up for a short squeeze. Tenderable grades are basically all committed or quite expensive, certified stocks amount to just 41’000 bales and speculators are about as short as we have ever seen them. Judging by the heavy spread activity this week some shorts are trying to escape the squeeze by rolling forward, hoping for something to bail them out along the way. This has led to a flattening of the price curve, with March, May and July today closing within 35 points. A week ago the March/July spread was still at 172 points! We believe that this backwardation process will get more pronounced over the next four months and that current crop futures will move to a premium over December, similar to what we saw last season.

With the AWP moving up 150 points next week, a lot of cotton is moving out of the loan or is being “popped”. The trade has been selling futures in order to hedge some of this freed loan cotton, but with just a little over four million bales of US Upland cotton unsold, there are not a lot of short futures needed anymore. Furthermore, as these newly established basis-long positions are being sold, futures will have to be bought back, which is why we believe that the trade will be a net buyer of current crop futures going forward. New crop is a different story, as growers will use strength to put some short hedges in place. This should reinforce the above-mentioned inversion of current crop over new crop futures.

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